Today, it is exactly 130 years since the greatest economist of the 20th century (and perhaps of all time) Ludwig von Mises was born. Let’s hope that in the heaven of economists where he has gone, the free and unhampered market economy is not just an imaginary construction, but reality.

I found the following succinct summary of the evil of inflation in George Reisman’s essay “Production versus Consumption”:

… for everyone who spends newly created money and thereby obtains goods and services, there must be others who suffer a corresponding loss. Their loss […] takes the form either of a depletion of their capital, a diminution of their consumption, or a lack of reward for the added labor they perform – a loss precisely corresponding to the goods and services obtained by the buyers who do not produce.

I know you have been dead for many years and cannot read and answer this; but I simply do not know whom else I should address.

You were always a staunch advocate of the gold standard – and I have always assumed you meant a pure, 100% gold standard, not some diluted version. For example, in Galt’s Gulch only gold and silver were used as media of exchange, not the worthless paper money that circulated in the outside world. And Francisco, in his money speech, said: “Those pieces of paper, which should have been gold…”, not: “Those pieces of paper, which should have been partially backed by gold…”

So – although you never explicitly addressed this issue in your writings – I have assumed that you were opposed to the practice of issuing bank notes, or other media of exchange, that are not fully covered by gold and/or silver, and that you would regard this practice as a form of counterfeiting. I have assumed this on the basis of my own understanding of both economics and Objectivism. I have assumed that if one holds honesty as a virtue, one would not endorse such a dishonest practice. I have assumed that if one does not want to seek the unearned, one would not want to cheat others out of their money in this way.

For this reason, I was severely disappointed to read the following in an interview with one of your students and followers, Dr. John Ridpath:

I vividly remember another example of her ability to go to fundamentals to clear up a debate. After a Ford Hall appearance, back at her hotel suite, one of us asked her if she could help with a debate many of us were involved in. The issue was: is fractional-reserve banking, because of its creation of expanded credit on a given base, implicit theft or legitimate banking practice. We – several of us doctoral students, if not already PhDs in economics – were split on this issue. With characteristic focus, she asked several questions, revealing a surprising understanding, and then – bingo – the answer was evident to her. It is appropriate – it is a matter of informed, calculated risk and, in essence, not theft at all. (100 Voices: An Oral history of Ayn Rand, p. 353f.)

Bingo? – I don’t know what arguments were forwarded in this discussion, but it is obvious that you were led up a garden path. So let me explain, in some detail, why fractional reserve banking is indeed counterfeiting and in what way it steals money from honest, hard-working citizens.

Inflating the money supply leads inevitably to rising prices – this much is uncontroversial (even mainstream economists have some inkling of this fact). But the prices don’t rise uniformly. New money always enters the economic blood stream at some specific point. Some people get the newly created money first. Prices have not yet risen. They are in a position to buy at the old prices. As the new money ripples through the economy, prices rise. Then the people who are last in line to receive the new money (or even do not receive it at all) will have to bear the brunt of paying the higher prices.

Is this fair? Is this just?

In today’s world, where the generation of new money is in the hands of the governments and their central banks, the newly created money comes into the hands of the friends of the government: it may go to some branch of industry that the government, for some reason, wishes to subsidize. (In periods of war, it typically goes to the weapons and munitions industries; in periods of peace, it might go to road-building or whatever the government sees fit to subsidize.)

Objectivists do understand that inflation is a bad thing; and they do understand that the government is the culprit and that the government should not meddle and intervene in the economy; that it should adopt a policy of “hands off” or “laissez-faire”. But most of them (with some notable exceptions, one of them being your own student, George Reisman) believe that the same policy is acceptable, when performed by private banks. They envisage an economy on an gold standard with no central bank and no government interference, where private banks are competing in making loans. Under such a system, they claim, it is perfectly proper for the banks to make bank notes and lend out money that is not fully backed by gold (and/or silver). Why? Because the money is then not forced on you by the government; it is a voluntary transaction; it is a normal market phenomenon; it is, with your own words, “a matter of informed, calculated risk and, in essence, not theft at all”.

But the truth is that those fractional loans are also inflationary. The scale is smaller, but this is a difference in degree, not in kind. Just as with ordinary inflation, prices will rise, but they will not rise uniformly. Those who receive the fractional loans can spend the money before prices have risen; and those who don’t get such loans will have to bear the brunt of the rising prices. The case against fractional reserve banking is exactly the same as the case against government induced inflation.

And where is the “informed, calculated risk”? This phrase could be used of any counterfeiter. If I print some notes and then go out to buy something, I take a calculated risk: my notes might be accepted, or they might not, depending on my counterfeiting skills. (Of course, I also take the calculated risk of having to go to jail.) This does not change, if there are people who accept my notes, well knowing they are counterfeit but expecting them to be so well counterfeited that they will be accepted.

I have to stress this point, since the defenders of fractional reserve banking make a point that the borrowers of fractional loans know very well that they are fractional, so they are not cheated; they are informed and take a calculated risk. But the non-borrowers – those who will end up paying the higher prices – are not informed at all!

If everyone were informed, this newly created money out of thin air would simply not be accepted. Secrecy on the part of the bank and its borrowers and ignorance on the part of the general public are a sine qua non when it comes to fractional banking.

Against every form of inflation, whether done by government-controlled central banks or private banks, there is an economic and a moral case. The economic case is that it leads to higher prices and causes misallocations. It leads to a “boom-bust” cycle, as Mises and other members of the “Austrian” school have explained so well. The moral case is that it cheats some people out of their hard-earned money; it is, indeed, a form of theft. And there is no dichotomy between the moral and the practical: the moral is the practical (as you yourself has explained so well).

George Reisman has said it best:

What underlies the practical advantages of the 100-percent-reserve gold standard over any form of fractional-reserve system is its moral superiority. It operates consistently with the law of excluded middle and does not attempt to cheat reality by getting away with a contradiction. It recognizes that lending money precludes retaining that money in one’s possession, and that retaining money in one’s possession precludes lending it. […]

Shysterism in any form is always slippery. Thus if it occurs to anyone to argue that the banks’ customers are not victims of fraud because they clearly know and understand that their funds are being lent out, then the answer is that in that case they would be parties to fraud. Their fraud would be the attempt to make payment to others not with money or reliable warehouse receipts for money, but with claims to debt. They would be engaged in the willful contradiction and deception of claiming to pay someone when in fact imposing on him the position of being a grantor of credit. (Capitalism: A Treatise on Economics, p.957f.)

Of course I understand that you are not in a position to answer me, and that it is unfair to write open letters to dead people. But John Ridpath and at least some of the other doctoral students and PhDs who took part in this discussion are still alive and could tell what was actually said in it. As I said, I cannot know what arguments were offered; I only know the conclusion, and I disagree emphatically with it.

Finally, I do hope this was an innocent error of knowledge on your part. I cannot support a philosophy that preaches virtues like honesty and justice and then endorses counterfeiting. The only “virtue” involved here is hypocrisy.

PS. In all fairness I must add that Ayn Rand otherwise had a very good understanding of money, of the nature of credit, and of the evil of inflation. Apart from Francisco’s money speech in Atlas Shrugged, I also recommend her essay “Egalitarianism and Inflation” in Philosophy: Who Needs It. That she did not apply these insights to the subject of fractional reserve banking in a free economy is something of a riddle.

Late update (November 2013): It should be noted that Alan Greenspan, in his article “Gold and Economic Freedom” in Capitalism: The Unknown Ideal, also wrote in favor of “fractional reserve banking”:

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security for his deposits). But the amount of gold that he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments. (P. 98 in the pocket edition of the book; italics mine.)

This statement must have been approved by Ayn Rand to be published in her book (and earlier, in her newsletter); so I have to assume that it is also part of “official Objectivist doctrine”, and that I am not an Objectivist, since I disagree with it.